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Updated on Wednesday, May 2, 2018
When you need cash but don’t want to raid your emergency fund, it’s only natural to consider tapping into what could be your greatest source of wealth — your home equity.
It’s entirely up to you how you use it, but many consumers use home equity to remodel their homes, consolidate debt or cover expensive bills, such as college tuition. It’s your equity to use how you please, so the options are endless.
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But because there’s more than one way to access your home equity, it’s wise to compare available options to find the right fit. Two of the most popular ways are a home equity line of credit (HELOC) and a cash-out refinance. Both of these loans can work if you want to access your home equity, but they do work rather differently.
Cash-out refinancing: How does it work?
Cash-out refinancing involves replacing your current home loan with a new one. The “cashing out” part of the equation requires you to take out a larger home loan than you currently have so you can receive the difference as a lump sum. Like HELOCs, this strategy works for people who have equity in their homes due to paying down their mortgage balances or appreciation of their property.
To qualify for a cash-out refinance, you need to meet similar requirements as you would if you were applying for a first mortgage. This typically means having a credit score of 620 or above, a debt-to-income ratio of 50% or less (i.e. the sum of all your debt payments, including housing, divided by your gross monthly income), and a loan-to-value ratio on your home of 80% or less after the cash out refinance is complete.
The equity part of the equation can be a roadblock since you need to have a lot of equity in your home to qualify for a cash-out refinance. Let’s say your home has a value of $300,000 and you want to take cash out. In that case, you could only borrow up to $240,000 through a cash-out refinance. If you owe that much or more on your home already, you wouldn’t qualify.
Like any other loan, you’ll need to prove your employment status via recent pay stubs and gather other documentation such as W-2 tax forms, two months of recent bank statements and two years of tax returns.
Cash-out refinance pros and cons
- You can use the money from a cash-out refinance for anything you want, including home upgrades, college tuition, a vacation or debt consolidation.
- If rates have gone down or your credit has improved since you took out your original home loan, you could refinance your mortgage into a new loan with a lower interest rate.
- You can choose from different types of loans for your refinance, with various terms and fixed or variable rates available.
- Interest on your first mortgage may be tax-deductible.
- Interest rates on first mortgages tend to be lower than other options, such as home equity loans or HELOCs.
- You may face substantial closing costs for a cash-out refinance, which typically work out to 2% to 6% of the loan amount.
- If interest rates have gone up since you purchased your home, you could be trading your mortgage for a higher interest loan that will be more expensive.
- Refinancing your home to take cash out may leave you in mortgage debt longer.
- You won’t qualify for a cash-out refinance unless you have at least 80% equity in your home after the process is complete.
- Refinancing your home to take cash out could leave you with a larger monthly mortgage payment.
Home equity line of credit (HELOC): How does it work?
While a cash-out refinance requires you to replace your current mortgage with a new one, a HELOC lets you keep your first mortgage exactly how it is. Acting as a second mortgage, a HELOC lets you borrow against your home equity via a line of credit. This strategy allows you to withdraw the money you want when you want it, then repay only the amounts you borrow.
To qualify for a HELOC, you need to have equity in your home. The Federal Trade Commission (FTC) notes that, depending on your creditworthiness and how much debt you have, you may be able to borrow up to 85% of the appraised value of your home after you subtract the balance of your first mortgage.
For example, let’s say your home is worth $300,000 and the balance on your mortgage is currently $200,000. A HELOC could make it possible for you to borrow up to $255,000, because you would still retain 85% equity after accounting for your first mortgage and your HELOC.
Generally speaking, HELOCs work a lot like a credit card. You typically have a “draw period” during which you can take out money to use for any purpose. Once that period ends, you may have the option to repay the loan amount over a specific amount of time or you might be required to repay the balance in full. You may also have the option to renew your draw period at that time. All these factors can vary, so make sure to ask your HELOC lender about specifics before you move forward.
Like credit cards, HELOCs also tend to come with variable interest rates. This can be a good thing when rates are low, but you have to be prepared for your rates to rise.
To qualify for a HELOC, you must be able to borrow the money you need and still maintain 15% equity in your home. Having a credit score of 680 or above can also help the process along, although some lenders offer home equity loans to borrowers with scores as low as 620.
Generally speaking, you also need to have a debt-to-income ratio of less than 43%, including your first mortgage and your HELOC payment. The Consumer Financial Protection Bureau (CFPB) reports that lenders implement this “43% rule” based on the idea that borrowers with higher levels of debt often have trouble keeping up with their housing payments.
HELOC pros and cons
- Applying for a HELOC allows you to maintain the terms of your original mortgage, which can be an advantage if your rate is low.
- You can use money from a HELOC for anything you want, and you only have to repay amounts you borrow.
- HELOCs tend to come with lower closing costs than traditional mortgages and home equity loans.
- Interest may be tax-deductible if you use the funds to improve your property. Make sure to check with your accountant.
- Taking out a HELOC means you’ll need to make two housing payments every month — your first mortgage payment and your HELOC payment.
- Interest on a HELOC is no longer tax-deductible, unless the funds are used for acquisition or updating your home.
- Since you only repay what you borrow and the interest rate on HELOCs is typically variable, you may not be able to anticipate what your monthly payment will be. Your monthly payment could also be interest only at first, meaning your payment won’t go toward the principal or help pay down the balance of your loan.
- The interest rate on HELOCs tends to be higher than first mortgages, and their variable rates can seem riskier. You may also be required to pay a balloon payment at the end of your loan, so make sure to read and understand the terms and conditions.
At a glance: Cash-out refinancing and HELOCs
At the end of the day, either borrowing option can get you what you need — access to the equity in your home. But, one option can easily be better than the other, depending on your situation.
Before you choose between a HELOC or a cash-out refinance, here are all the details you should consider:
You get to select the loan term when you go through a cash-out refinance. Among other options, you can get a fixed-rate mortgage with a 15-year or 30-year term.
Most HELOCS come with a draw period of up to 10 years. After that, you will have a repayment period that varies by lender.
You can borrow up to 80% of your home’s value.
HELOCs allow you borrow up to 85% of your home’s value, including your first mortgage.
How long it takes to get the money
The average refinance takes between 20 and 45 days, and you’ll get a lump sum for the amount you borrow at closing.
The average HELOC can close in less than 30 days, at which point you’ll have access to your new line of credit.
You need a credit score of 620 or higher to qualify for a cash out refinance.
You need a credit score of 620 or higher to qualify for a HELOC.
You need to have at least 20% equity in your home after the cash-out refinance is complete.
HELOCs require you to maintain at least 15% equity after borrowing.
Mortgage rates can be fixed or adjustable, with rates ranging from 3.75% to 4.25%.
HELOC interest rates are variable, currently ranging from 4% to 5.87%.
Closing costs for a traditional mortgage range from 2% to 6% of the loan amount.
HELOCs tend to have little or no closing costs.
Since you’re using your home as collateral, you run the risk of losing your home if you default. If you extend your repayment timeline, you will also spend more time in debt.
HELOCs require a lower amount of equity (15%) in your home, which means you can borrow more. However, you could lose your home if you default, because you’re using the property as collateral.
Which choice is right for you?
Before you decide between a HELOC or a cash-out refinance, it helps to take a holistic look at your personal finances and your goals.
A cash-out refinance may work better if:
- Your current home loan has a higher rate than you could qualify for now, so refinancing could help you save on interest
- You prefer the stability of a fixed monthly payment or only want to make one mortgage payment every month
- You have high-interest debts and want to consolidate them at the same rate as your new mortgage
- What you save by refinancing — such as savings from a lower interest rate — outweighs the fees that come with refinancing
A HELOC may work better if:
- You are happy with your first mortgage and don’t want to trade it for a new loan
- Your first mortgage has a lower interest rate than you can qualify for with today’s rates
- You aren’t sure how much money you need, so you prefer the flexibility of having a line of credit you can borrow against
- You want to be able to borrow up to 85% of your home’s value versus the 80% you can borrow with a cash-out refinance
In addition to these options, you can also consider a home equity loan. While HELOCs come with variable rates and work as a line of credit, a home equity loan comes with a fixed rate and fixed monthly payment.
Whatever you decide, make sure to compare lenders, interest rates and terms to get the best deal possible when accessing your home equity.